Deep value, contrarian, and Grahamite investment

Network Engines Inc (NASDAQ:NENG)

Network Engines Inc (NASDAQ:NENG) is a perennial inclusion on lists of net net stocks and so it should come as no surprise to see it back in net net land. In November 2007, an activist investor, Trinad Management, pushed the company to “immediately [implement] a share buy-back program.” The company demurred and has now seen its stock sink to all-time lows. In after-hours trading yesterday, NENG was up a little from those lows to $0.38 (it closed yesterday at $0.40), which gives it a market capitalization of $16.5M. We estimate its liquidation value at around 55% higher at $25.5M or $0.59 per share.

About NENG

NENG develops and manufactures application platform solutions that enable original equipment manufacturers, independent software vendors, and service providers to deliver software applications in the form of a network-ready device. The company offers application platform customers a suite of services associated with the design, development, manufacturing, brand fulfillment and post-sale support of these devices. It produces and fulfills devices for its customers, and derives revenues primarily from the sale of value-added hardware platforms to these customers. These customers subsequently resell and support the platforms under their own brands to their customer base. The company’s investor relations website can be found here.

The value proposition

NENG’s earnings and cash flow are patchy (its most recent 10K can be found here). Earnings have fallen in each of the last five quarters from $1.8M in the 2007 September quarter to -$9.7M in the 2008 September quarter. Cash from operating activities has been as high as $10.6M in the 12-months ending September 2007 and as low as -$5.4M in the preceding 12 months. As a result, there is some vestigial value on the balance sheet (the “Carrying” column shows the assets as they are carried in the financial statements, and the “Liquidating” column shows our estimate of the value of the assets in a liquidation):

NENG has $29M in receivables that we’ve written down by 20% to $23.2M or $0.54 per share, inventory of $21.4M that we’ve discounted by 33% to $14.3M or $0.33 per share and cash in the amount of $10M or $0.23 per share. The company has no debt. Deducting liabilities of $23.7M or $0.55 per share, we estimate NENG’s liquidation value at around $25.5M or $0.59.

NENG’s most recent 10K specifically sets out that it is not party to any special-purpose or off balance sheet entities created for the purpose of raising capital, incurring debt or operating parts of its business that are not consolidated into its financial statements.

The catalyst

Trinad Management filed its original 13D in November 2007 disclosing a 6.4% holding in NENG and attaching the following letter to NENG’s board:

We support Greg Shortell and the new management team at Network Engines and are encouraged by their accomplishments to date. We believe the focus of the sales and marketing efforts on diversifying the company’s customer base is yielding results and should allow for the continued generation of substantial free cash flow from operations.

Furthermore, we approve of management’s decision to acquire Alliance Systems, Inc. In our estimation, this acquisition should significantly increase shareholder value. It is our belief that the Company can realize increased sales through product portfolio expansion and cross selling opportunities. At the same time, synergies of the acquisition have provided Network Engines with the opportunity to significantly grow its business. The post-acquisition Network Engines should achieve economies of scale and will likely incur integration savings during FY 2008. The Alliance Systems acquisition and the shift in sales and marketing focus should result in an improved ability to successfully execute its business strategy.

Taking these positive events and Network Engines’ current and long term commitments into account, our financial analysis suggests that the Company currently has approximately $10 million in cash on its balance sheet and no funded indebtedness. In addition, our conservative projections indicate that the Company will generate an additional $10 million (or more) in free cash flow during the next 12 months. Accordingly, we strongly believe that this board and management has an obligation to dedicate a portion of its cash reserve and free cash flow to projects which have the greatest return to shareholders such as a share buy-back program. We request that the Board of Directors consider whether shareholder returns on other proposed uses of these excess funds are indeed superior to a share buy-back.

The Company’s stock hit a new 52 week low today (November 15, 2007) despite the impressive efforts and results posted by this management team. We appeal to the Board of Directors to consider immediately implementing a share buy-back program as it is in the best long-term interest of both the Company and its shareholders.

We believe that the Company is significantly undervalued and that a share buy-back program would improve investors’ overall perception of Network Engines’ equity value. Such a program could result in a reduction in the relative value discount currently applied to Network Engines’ stock by the investor community, by amongst other things demonstrating that this Board has confidence in the Company’s ability to execute its business plan. If the Board were to apply the same valuation metrics to its own stock as it did to the recently completed acquisition of Alliance Systems Inc., they would undoubtedly conclude that at these price levels the Company’s shares represent an equal or greater value than Alliance Systems. Most importantly, a smartly implemented buyback program could allow the company to materially reduce its number of outstanding shares thereby generating long term shareholder value in the most tax efficient manner. As a significant equity holder and long term investor, this is of far greater value then any short term impact to share price.

We encourage the Board of Directors and management to consider and adopt this strategy immediately and speak with other shareholders of the Company who may be equally frustrated and share our views. We would be willing to meet with the Board of Directors and work collaboratively to assist with the development of a long-term value creation plan that would benefit all shareholders.
Sincerely,

/s/ Jay Wolf
Trinad Management, LLC

Trinad Management continued to buy stock in NENG, disclosing in an amended 13D a slightly increased 6.98% holding in July last year.

Conclusion

As we mentioned in the introduction, NENG is a perennial net net stock. Jonathan Heller of Cheap Stocks-fame mentioned it back in October 2005 in a list of the Top 20 Market Cap Companies Trading Below Net Current Asset Value. It was then trading around $1.30 against a net current asset value of around $1.31. Investors buying back in October 2005 had plenty of opportunity to unload the stock at a profit while it traded up to $3.17 in March 2006. NENG’s stock has since dropped pretty consistently to its present $0.38, but its liquidating value has not fallen as far. At $0.59 per share, NENG’s liquidation value is 55% higher than its stock price, which is a significant margin of safety. We’re adding it to the Greenbackd Portfolio at $0.38.

NENG traded after hours yesterday at $0.38.

The S&P500 Index closed yesterday at 870.26.

[Full Disclosure: We do not have a holding in NENG. This is neither a recommendation to buy or sell any securities. All information provided believed to be reliable and presented for information purposes only. Do your own research before investing in any security.]